Turmoil exposes risks in $9B pension fund

Maybe I’m an incurable optimist, but I see a silver lining in the recently stormy financial markets — the jolt might just wake up elected officials to the actual risks they are taking with public money in San Diego County’s pension fund.

In 2010, the board responsible for the county’s $9.4 billion fund gave its new investment adviser a green light to pursue a relatively new investment strategy known in the hedge fund industry as “risk parity.”

Advocates say the strategy is the closest thing yet to an investing free lunch: Using leverage and sophisticated mathematics, you can make higher returns with lower risk than traditional portfolios.

If risk parity sounds too good to be true, that’s because it is, according to a host of prominent critics.

“This is all bull,” said Zvi Bodie, a Boston University economist and finance professor who is a frequent critic of the financial services industry. “It is scary, and it’s very scary that anyone would believe it.”

“Nonsense,” is how Warren Buffett, the world’s most successful investor, describes Modern Portfolio Theory, the intellectual basis for risk-parity strategy. “Asinine,” is the term preferred by his business partner, Charlie Munger.

MPT holds that an investor can infer the risk of a security by calculating how far its price swings up and down in the markets over time. Risk parity involves loading up on supposedly low-risk investments to boost returns.

Buffett points out that price swings tell you nothing about a company’s true risk — that it might go bankrupt and default on its bonds. Indeed, if you find a well-managed company and wait to buy its stock until after the price crashes, you’ve actually reduced the risk of losing money on that investment. Volatility is not the same as risk.

Indeed, market volatility has hammered risk-parity hedge funds recently, just as San Diego County has increased its bets on the strategy. The Wall Street Journal reported last week that such funds have lost up to 8 percent so far this year, and lag roughly 13 percent behind funds that replicate the traditional pension portfolio of 60 percent stocks and 40 percent bonds.

What scares me most is the amount of leverage they use. Under Lee Partridge, the outside adviser who controls the fund’s investments, San Diego County uses derivatives to generate $1.35 in market exposure for each $1 it really has.

There are other reasons to worry. When the pension fund hired Partridge in late 2009, the county was his only client. A bond trader by experience, this was his first time directing the investments of an entire pension fund.

And he was recommended by Hewitt Ennisknupp, the county’s consulting firm that is supposed to provide independent advice on whether a manager is steering the fund off a cliff. Not surprisingly, the firm endorsed Partridge’s venture into leveraged risk parity.

The pension board recently corrected that shortcoming by replacing Ennisknupp, but the new firm hasn’t given its views on the county’s investment policy.

According to the fund’s 2012 annual report, Partridge has used the fund’s 35 percent leverage level to bet heavily on bonds, mostly U.S. Treasuries.